corporation finance chapter 01

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Page 1: Corporation Finance Chapter 01

McGraw-Hill/IrwinCorporate Finance, 7/e

Page 2: Corporation Finance Chapter 01

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McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

CHAPTER

1Introduction to

Corporate Finance

Page 3: Corporation Finance Chapter 01

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McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

Chapter Outline

1.1 What is Corporate Finance?

1.2 Corporate Securities as Contingent Claims on Total Firm Value

1.3 The Corporate Firm

1.4 Goals of the Corporate Firm

1.5 Financial Markets

1.6 Outline of the Text

1.1 What is Corporate Finance?

1.2 Corporate Securities as Contingent Claims on Total Firm Value

1.3 The Corporate Firm

1.4 Goals of the Corporate Firm

1.5 Financial Markets

1.6 Outline of the Text

Page 4: Corporation Finance Chapter 01

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McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

What is Corporate Finance?

Corporate Finance addresses the following three questions:

1. What long-term investments should the firm engage in?

2. How can the firm raise the money for the required investments?

3. How much short-term cash flow does a company need to pay its bills?

Corporate Finance addresses the following three questions:

1. What long-term investments should the firm engage in?

2. How can the firm raise the money for the required investments?

3. How much short-term cash flow does a company need to pay its bills?

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The Balance-Sheet Modelof the Firm

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Total Value of Assets:

Shareholders’ Equity

Current Liabilities

Long-Term Debt

Total Firm Value to Investors:

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McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

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The Balance-Sheet Modelof the Firm

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

What long-term investments should the firm engage in?

The Capital Budgeting Decision

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The Balance-Sheet Modelof the Firm

How can the firm raise the money for the required investments?

The Capital Structure Decision

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

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The Balance-Sheet Modelof the Firm

How much short-term cash flow does a company need to pay its bills?

The Net Working Capital Investment Decision

Net Working Capital

Shareholders’ Equity

Current Liabilities

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Long-Term Debt

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McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

Capital Structure

The value of the firm can be thought of as a pie.

The goal of the manager is to increase the size of the pie.

The Capital Structure decision can be viewed as how best to slice up a the pie.

If how you slice the pie affects the size of the pie, then the capital structure decision matters.

50% Debt

50% Equity

25% Debt

75% Equity

70% Debt

30% Equity

Page 10: Corporation Finance Chapter 01

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McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

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Hypothetical Organization Chart

Chairman of the Board and Chief Executive Officer (CEO)

Board of Directors

President and Chief Operating Officer (COO)

Vice President and Chief Financial Officer (CFO)

Treasurer Controller

Cash Manager

Capital Expenditures

Credit Manager

Financial Planning

Tax Manager

Financial Accounting

Cost Accounting

Data Processing

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The Financial Manager

To create value, the financial manager should:

1. Try to make smart investment decisions.

2. Try to make smart financing decisions.

To create value, the financial manager should:

1. Try to make smart investment decisions.

2. Try to make smart financing decisions.

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Cash flowfrom firm (C)

The Firm and the Financial Markets

Tax

es (D)

Firm

Government

Firm issues securities (A)

Retained cash flows (F)

Investsin assets(B)

Dividends anddebt payments (E)

Current assetsFixed assets

Financialmarkets

Short-term debt

Long-term debt

Equity shares

Ultimately, the firm must be a cash generating activity.

The cash flows from the firm must exceed the cash flows from the financial markets.

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1.2 Corporate Securities as Contingent Claims on Total Firm Value

The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount of by a certain date.

The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid.

If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.

The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount of by a certain date.

The shareholder’s claim on firm value is the residual amount that remains after the debtholders are paid.

If the value of the firm is less than the amount promised to the debtholders, the shareholders get nothing.

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Debt and Equity as Contingent Claims

$F

$F

Payoff to debt holders

Value of the firm (X)

Debt holders are promised $F.

If the value of the firm is less than $F, they get the whatever the firm if worth.

If the value of the firm is more than $F, debt holders get a maximum of $F.

$F

Payoff to shareholders

Value of the firm (X)

If the value of the firm is less than $F, share holders get nothing.

If the value of the firm is more than $F, share holders get everything above $F.

Algebraically, the bondholder’s claim is: Min[$F,$X]

Algebraically, the shareholder’s claim is: Max[0,$X – $F]

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$F

$F

Combined Payoffs to debt holders and shareholders

Value of the firm (X)

Debt holders are promised $F.

Payoff to debt holders

Payoff to shareholders

If the value of the firm is less than $F, the shareholder’s claim is: Max[0,$X – $F] = $0 and the debt holder’s claim is Min[$F,$X] = $X.

The sum of these is = $X

If the value of the firm is more than $F, the shareholder’s claim is: Max[0,$X – $F] = $X – $F and the debt holder’s claim is:

Min[$F,$X] = $F.

The sum of these is = $X

Combined Payoffs to Debt and Equity

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1.3 The Corporate Firm

The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash.

However, businesses can take other forms.

The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash.

However, businesses can take other forms.

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Forms of Business Organization

The Sole ProprietorshipThe Partnership

General PartnershipLimited Partnership

The CorporationAdvantages and Disadvantages

Liquidity and Marketability of OwnershipControlLiabilityContinuity of ExistenceTax Considerations

The Sole ProprietorshipThe Partnership

General PartnershipLimited Partnership

The CorporationAdvantages and Disadvantages

Liquidity and Marketability of OwnershipControlLiabilityContinuity of ExistenceTax Considerations

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A Comparison of Partnershipand Corporations

  Corporation Partnership

Liquidity Shares can easily be exchanged.

Subject to substantial restrictions.

Voting Rights Usually each share gets one vote

General Partner is in charge; limited partners may have some voting rights.

Taxation Double Partners pay taxes on distributions.

Reinvestment and dividend payout

Broad latitude All net cash flow is distributed to partners.

Liability Limited liability General partners may have unlimited liability. Limited partners enjoy limited liability.

Continuity Perpetual life Limited life

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1.4 Goals of the Corporate Firm

The traditional answer is that the managers of the corporation are obliged to make efforts to maximize shareholder wealth.

The traditional answer is that the managers of the corporation are obliged to make efforts to maximize shareholder wealth.

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The Set-of-Contracts Perspective

The firm can be viewed as a set of contracts.

One of these contracts is between shareholders and managers.

The managers will usually act in the shareholders’ interests.

The shareholders can devise contracts that align the incentives of the managers with the goals of the shareholders.

The shareholders can monitor the managers behavior.

This contracting and monitoring is costly.

The firm can be viewed as a set of contracts.

One of these contracts is between shareholders and managers.

The managers will usually act in the shareholders’ interests.

The shareholders can devise contracts that align the incentives of the managers with the goals of the shareholders.

The shareholders can monitor the managers behavior.

This contracting and monitoring is costly.

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Managerial Goals

Managerial goals may be different from shareholder goals

Expensive perquisites

Survival

Independence

Increased growth and size are not necessarily the same thing as increased shareholder wealth.

Managerial goals may be different from shareholder goals

Expensive perquisites

Survival

Independence

Increased growth and size are not necessarily the same thing as increased shareholder wealth.

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Separation of Ownership and Control

Board of Directors

Management

AssetsDebt

Equity

Shareholders

Debtholders

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Do Shareholders ControlManagerial Behavior?

Shareholders vote for the board of directors, who in turn hire the management team.

Contracts can be carefully constructed to be incentive compatible.

There is a market for managerial talent—this may provide market discipline to the managers—they can be replaced.

If the managers fail to maximize share price, they may be replaced in a hostile takeover.

Shareholders vote for the board of directors, who in turn hire the management team.

Contracts can be carefully constructed to be incentive compatible.

There is a market for managerial talent—this may provide market discipline to the managers—they can be replaced.

If the managers fail to maximize share price, they may be replaced in a hostile takeover.

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1.5 Financial Markets

Primary MarketWhen a corporation issues securities, cash flows from investors to the firm.

Usually an underwriter is involved

Secondary MarketsInvolve the sale of “used” securities from one investor to another.

Securities may be exchange traded or trade over-the-counter in a dealer market.

Primary MarketWhen a corporation issues securities, cash flows from investors to the firm.

Usually an underwriter is involved

Secondary MarketsInvolve the sale of “used” securities from one investor to another.

Securities may be exchange traded or trade over-the-counter in a dealer market.

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Financial Markets

FirmsInvestors

Secondary Market

money

securitiesSueBob

Stocks and Bonds

Money

Primary Market

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Exchange Trading of Listed Stocks

Auction markets are different from dealer markets in two ways:

Trading in a given auction exchange takes place at a single site on the floor of the exchange.

Transaction prices of shares are communicated almost immediately to the public.

Auction markets are different from dealer markets in two ways:

Trading in a given auction exchange takes place at a single site on the floor of the exchange.

Transaction prices of shares are communicated almost immediately to the public.

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1.6 Outline of the Text

I. Overview

II. Value and Capital Budgeting

III. Risk

IV. Capital Structure and Dividend Policy

V. Long-Term Financing

VI. Options, Futures and Corporate Finance

VII. Financial Planning and Short-Term Finance

VIII. Special Topics

I. Overview

II. Value and Capital Budgeting

III. Risk

IV. Capital Structure and Dividend Policy

V. Long-Term Financing

VI. Options, Futures and Corporate Finance

VII. Financial Planning and Short-Term Finance

VIII. Special Topics